ACCA P1 Governance, Risk and Ethics - 2011 - Study text - Emile Woolf Publishing
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Paper P1: Governance, risk and ethics
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the company chairman (board chairman) and the managing director (often
called the chief executive officer or CEO).
The board of directors take many decisions as a group, but they also have
individual interests in the company. Directors are therefore stakeholders in their
company both as a unit and as separate individuals.
3.4 Other internal stakeholders
Employees can be an important internal stakeholder group. It might be possible to
divide employees into sub-groups, each with a different set of interests and
expectations, and each with a different amount of influence over the actions of the
company.
It might be appropriate to separate senior management and other employees
into two separate stakeholder groups. Senior management might have a bigger
interest in the profits and share price of the company because they belong to a
share incentive scheme or share option scheme, or because they receive annual
bonus payments based on the company’s profitability. Other employees who do
not have such incentives will have much less interest in the financial
performance of the company or its share price.
Some employees might be able to demand large rewards from the company or
might exercise strong influence because of their value to the company. For
example, in the UK some individual investment bankers have a strong influence
within their bank because of the specialist skills they possess and the income
they are able to earn or the bank.
In some companies, there might be a strong trade union influence. The ability of a
company to alter its working practices, for example, may depend on obtaining the
co-operation and support of the trade unions.
3.5 External stakeholders
A company has external stakeholders as well as internal stakeholders. External
stakeholders are individuals or groups who do not work for the company but who
nevertheless have an interest in what the company does and who might be able to
influence the way in which the company is governed.
Lenders have an interest in a company to which they lend money. They expect
to be paid what they are owed. Usually a lender will not be closely involved in
the governance or management of a company, but they will monitor its financial
performance and financial position. Lenders will also become significant
stakeholders if the company gets into financial difficulties and is faced with the
risk of insolvency.
Suppliers have an interest in companies who are their major customers,
although their influence over its governance might be small.
Regulators have an interest in companies whose activities they are required to
regulate. Some aspects of regulation have a major impact on the way in which a
company is governed. For example, quoted companies must comply with the
rules set by the securities regulator (such as the Securities Exchange Commission
in the US and the Financial Services Authority in the UK).
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Government has a stake in companies. Companies are a source of tax revenue
and also collect tax (income taxes and sales taxes) for the government from
employees and customers. For some companies, such as companies that
manufacture defence equipment, the government might have an influence as a
major customer for the goods that the company produces.
Customers, the general public or special interest groups might have a
significant influence over a company, especially a company that relies for
success on the high reputation of its products or services.
Stock exchanges have an influence over the governance of quoted companies,
because companies must comply with the rules of the stock exchange on which
their shares are traded.
A company’s auditors should also have some influence over the governance of a
company, by making sure that the board of directors presents financial
statements to the shareholders that present a true and fair view of the company’s
financial position and performance.
Investors are a major influence over companies whose shares are traded on a
stock exchange. Investors decide what the market price of a company’s shares
should be. A company needs to satisfy the expectations not only of its
shareholders, but of the investing community in general, if it wishes to sustain or
increase the share price (and so the total value of the company).
3.6 Institutional investors
Institutional investors are entities that specialise in investing, mainly in shares and
bonds. There are several types of institutional investor.
Pension funds. These institutions hold funds that will be used to provide
pensions to individuals after their retirement. Pension funds may be sponsored
by an employer, or may be private pension schemes of individuals. Until the
money is needed to pay a pension, it is invested to earn a return.
Insurance companies. The funds of insurance companies come from insurance
policy premiums and life assurance premiums. Until the money is needed for
payment to the insurance policy holders, it is invested.
Mutual funds. Mutual funds are funds of many individual investors, who invest
relatively small amounts of money in the fund. The investments of the many
different individuals are combined and invested collectively. In the UK, the main
types of mutual funds are unit trusts and Open-Ended Investment Companies or
OEICs.
Institutional investors are significant stakeholders on companies, in any country
where they invest large funds. They are particularly influential in the US and UK.
Individually, an institutional investor might hold only a small proportion of the
shares in a large public company. However, by joining together and speaking
collectively, a group of institutional investors might be able to have some
influence over the decisions of a company’s board of directors.
Most institutional investors belong to a ‘trade association’. In the UK, for
example, most pension funds are members of the National Association of
Pension Funds (NAPF) and most insurance companies are members of the
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Association of British Insurers (ABI). Each of these trade associations give
information and advice to their members about corporate governance matters,
and might recommend how they should vote on certain issues at the general
meetings of companies. Collectively, bodies such as the NAPF and ABI (and
their members) can have a major influence on companies because of the
significance of their members as investors and shareholders.
In the UK for example, the influence of the institutional investors has been
significance in persuading listed companies to adopt (most of) the provisions of the
Combined Code on corporate governance. Their role in promoting good corporate
governance has therefore been critically important.
In the UK, a section of the Combined Code on corporate governance contains
principles about the role of institutional investors in contributing to good
corporate governance.
The institutional shareholder bodies have issued guidelines on corporate
governance to their members, which they encourage their members to apply.
The institutional shareholder bodies issue regular advice to members on how
they should consider voting on certain issues at general meetings of particular
companies. For example, the NAPF or ABI might recommend to their members
that they should vote against the re-election of a particular director, or should
vote against the directors’ remuneration report, or against a proposed takeover
bid.
Corporate governance and investor confidence
Institutional investors are also important because their views are a good reflection
of investor confidence in the stock market. Bad corporate governance could
eventually damage the confidence of investors and make them much less willing to
invest in shares. This in turn will keep share prices – and company values – down,
and will make it difficult for companies to raise fresh capital in the financial markets
when they need it.
Arthur Levitt, a former chairman of the US Securities and Exchange Commission,
made the following comments at the time of the Enron collapse (and a heavy fall in
stock market prices generally in the US): ‘If a country does not have a reputation for
strong corporate governance practice, capital will flow elsewhere. If investors are
not confident with the level of disclosure, capital will flow elsewhere. If a country
opts for lax accounting and reporting standards, capital will flow elsewhere. All
enterprises in that country, regardless of how steadfast a particular company’s
practices, may suffer the consequences…. Markets exist by the grace of investors
and it is today’s more empowered investors who will determine which companies
and which markets will stand the test of time and endure the weight of greater
competition. It serves us well to remember that no market has a divine right to
investors’ capital.’
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Paper P1
Governance,riskandethics
CHAPTER
2
Agency relationships
and theories
Contents
1 Agency theory
2 Transaction cost economics theory
3 Stakeholder theory
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Agency theory
The law of agency
Concepts in agency theory: the agency relationship
Agency conflicts
Agency costs
Reducing the agency problem
Accountability of agents
Ethics and agency theory
Agency conflicts in other types of organisation
Agency realationships – An overview
1 Agency theory
1.1 The law of agency
An agent is a person who acts on behalf of another person, the principal, in dealing
with other people. For example, a selling agent acts on behalf of a principal, a
manufacturer of goods, to sell goods on the manufacturer’s behalf. Similarly, a stock
broker is an agent who acts on behalf of a client (the principal) to buy or sell shares
on the client’s behalf. The agent acts on the name of the principal, and commits the
principal to agreements and transactions.
In company law, the directors act as agents of the company. The board of directors
as a whole, and individual directors, have the authority to bind the company to
contractual agreements with other parties.
Since most of the powers to act on behalf of the company are given to the board of
directors, the directors (and the management of a company) have extensive powers
in deciding what the company should do, what its objectives should be, what its
business strategies should be, how it should invest and what its targets for
performance should be.
The powerful position of the directors raises questions about the use of this power,
especially where the owners of the company (its shareholders) and the directors are
different individuals.
How can the owners of the company make sure that the directors are acting in
the best interests of the shareholders?
If the directors act in ways that the shareholders do not agree with, what can the
shareholders do to make the directors act differently?
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Fiduciary duty of directors
As agents of the company, directors have a fiduciary duty to the company. A
fiduciary duty is a duty of trust. A director must act on behalf of the company in
total good faith, and must not put his personal interests before the interests of the
company.
If a director is in breach of this fiduciary duty he could be held liable in law, if the
company were to take legal action against him. Legal action by a company against a
director for breach of fiduciary duty would normally be taken by the rest of the
board of directors or, possibly, a majority of the shareholders acting in the name of
the company.
Agency law and challenging the actions of directors
In practice, it is very difficult for shareholders to use the law to challenge the
decisions and actions of the company’s directors. If shareholders believe that the
directors are not acting in the best interests of the company, their ability to do
something about the problem is restricted.
The shareholders can vote to remove any director from office, but this requires a
majority vote by the shareholders, which might be difficult to obtain.
In a court of law, shareholders would have to demonstrate that the directors
were actually acting against the interests of the company, or against the clear
interests of particular shareholders, in order to persuade the court to take legal
measures against the directors.
In summary, although there is a legal relationship between the board of directors
and their company, the shareholders cannot easily use the law to control the
decisions or actions that the directors take on behalf of the company.
1.2 Concepts in agency theory: the agency relationship
Whereas agency law deals with the legal relationship between a company and its
directors, the theory of agency deals with the relationship between:
a company’s owners and
its managers (directors).
Agency theory is based on the idea that when a company is first established, its
owners are usually also its managers. As a company grows, the owners appoint
managers to run the company. The owners expect the managers to run the company
in the best interests of the owners; therefore a form of agency relationship exists
between the owners and the managers.
Many companies borrow, and a significant proportion of the long-term capital of a
company might come from various sources of debt capital, such as bank loans, lease
finance and bond issues (debentures, loan stock and so on). Major lenders also have
an interest in how the company is managed, because they want to be sure that the
company will be able to repay the debt with interest.
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The agency relationship
Agency theory was developed by Jensen and Meckling (1976). They suggested a
theory of how the governance of a company is based on the conflicts of interest
between the company’s owners (shareholders), its managers and major providers of
debt finance.
Each of these groups has different interests and objectives.
The shareholders want to increase their income and wealth. Their interest is
with the returns that the company will provide in the form of dividends, and
also in the value of their shares. The value of their shares depends on the long-
term financial prospects for the company. Shareholders are therefore concerned
about dividends, but they are even more concerned about long-term profitability
and financial prospects, because these affect the value of their shares.
The managers are employed to run the company on behalf of the shareholders.
However, if the managers do not own shares in the company, they have no
direct interest in future returns for shareholders, or in the value of the shares.
Managers have an employment contract and earn a salary. Unless they own
shares, or unless their remuneration is linked to profits or share values, their
main interests are likely to be the size of their remuneration package and their
status as company managers.
The major providers of debt have an interest in sound financial management by
the company’s managers, so that the company will be able to pay its debts in full
and on time.
Jensen and Meckling defined the agency relationship as a form of contract between
a company’s owners and its managers, where the owners (as principal) appoint an
agent (the managers) to manage the company on their behalf. As a part of this
arrangement, the owners must delegate decision-making authority to the
management.
The owners expect the agents to act in the best interests of the owners. Ideally, the
‘contract’ between the owners and the managers should ensure that the managers
always act in the best interests of the owners. However, it is impossible to arrange
the ‘perfect contract’, because decisions by the managers (agents) affect their own
personal welfare as well as the interests of the owners.
This raises a fundamental question. How can managers, as agents of their company,
be induced or persuaded to act in the best interests of the shareholders?
1.3 Agency conflicts
Agency conflicts are differences in the interests of a company’s owners and
managers. They arise in several ways.
Moral hazard. A manager has an interest in receiving benefits from his or her
position as a manager. These include all the benefits that come from status, such
as a company car, a private chauffeur, use of a company airplane, lunches,
attendance at sponsored sporting events, and so on. Jensen and Meckling
suggested that a manger’s incentive to obtain these benefits is higher when he
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has no shares, or only a few shares, in the company. The biggest problem is in
large companies.
Effort level. Managers may work less hard than they would if they were the
owners of the company. The effect of this ‘lack of effort’ could be lower profits
and a lower share price. The problem will exist in a large company at middle
levels of management as well as at senior management level. The interests of
middle managers and the interests of senior managers might well be different,
especially if senior management are given pay incentives to achieve higher
profits, but the middle managers are not.
Earnings retention. The remuneration of directors and senior managers is often
related to the size of the company, rather than its profits. This gives managers an
incentive to grow the company, and increase its sales turnover and assets, rather
than to increase the returns to the company’s shareholders. Management are
more likely to want to re-invest profits in order to make the company bigger,
rather than pay out the profits as dividends. When this happens, companies
might invest in capital investment projects where the expected profitability is
quite small, and the net present value might be negative.
Risk aversion. Executive directors and senior managers usually earn most of
their income from the company they work for. They are therefore interested in
the stability of the company, because this will protect their job and their future
income. This means that management might be risk-averse, and reluctant to
invest in higher-risk projects. In contrast, shareholders might want a company to
take bigger risks, if the expected returns are sufficiently high. Shareholders often
invest in a portfolio of different companies; therefore it matters less to them if an
individual company takes risks.
Time horizon. Shareholders are concerned about the long-term financial
prospects of their company, because the value of their shares depends on
expectations for the long-term future. In contrast, managers might only be
interested in the short-term. This is partly because they might receive annual
bonuses based on short-term performance, and partly because they might not
expect to be with the company for more than a few years. Managers might
therefore have an incentive to increase accounting return on capital employed
(or return on investment), whereas shareholders have a greater interest in long-
term value as measured by net present value.
1.4 Agency costs
Agency costs are the costs of having an agent to make decisions on behalf of a
principal. Applying this to corporate governance, agency costs are the costs that the
shareholders incur by having managers to run the company instead of running the
company themselves.
Agency costs do not exist when the owners and the managers are exactly the
same individuals.
Agency costs start to arise as soon as some of the shareholders are not also
directors of the company.
Agency costs are potentially very high in large companies, where there are many
different shareholders and a large professional management.
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Agency costs can therefore be defined as the ‘value loss’ to shareholders that arises
from the divergence of interests between the shareholders and the company’s
management.
There are three aspects to agency costs:
They include the costs of monitoring. The owners of a company can establish
systems for monitoring the actions and performance of management, to try to
ensure that management are acting in their best interests. An example of
monitoring is the requirement for the directors to present an annual report and
accounts to the shareholders, setting out the financial performance and financial
position of the company. These accounts are audited, and the auditors present a
report to the shareholders. Preparing accounts and having them audited has a
cost.
Agency costs also include the costs to the shareholder that arise when the
managers take decisions that are not in the best interests of the shareholders (but
are in the interests of the managers themselves). For example, agency costs arise
when a company’s directors decide to acquire a new subsidiary, and pay more
for the acquisition than it is worth. The managers would gain personally from
the enhanced status of managing a larger group of companies. The cost to the
shareholders comes from the fall in share price that would result from paying
too much for the acquisition.
The third aspect of agency costs is costs that might be incurred to provide
incentives to managers to act in the best interests of the shareholders. These are
sometimes called bonding costs. These costs are intended to reduce the size of
the agency problem. Directors and other senior managers might be given
incentives in the form of free shares in the company, or share options. In
addition, directors and senior managers might be paid cash bonuses if the
company achieves certain specified financial targets. The remuneration packages
for directors and senior managers are therefore an important element of agency
costs.
Agency costs: summary
Agency costs can be summarised as follows
Monitoring costs
Costs of measuring, observing and controlling the behaviour of
management. Some costs are imposed by law (annual accounts, annual
audit) and some arise from compliance with codes of corporate
governance.
+ Bonding costs
Costs of arrangements that help to align the interests of the
shareholders and managers.
+ Residual loss
Losses occur for the owners, such as the losses arising from a lower
share price, because the managers take decisions and actions that are
not in the best interests of the shareholders. Monitoring costs and
bonding costs will not prevent some residual loss from occurring.
1.5 Reducing the agency problem
Jensen and Meckling argued that when they act in the interest of the shareholders,
managers bear the entire cost of failing to pursue goals that are in their own best
interests, but gain only a few of the benefits. Incentives should therefore be
provided to management to increase their willingness to take ‘value-maximising
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decisions’ – in other words, to take decisions that benefit the shareholders by
maximising the value of their shares.
Several methods of reducing the agency problem have been suggested. These
include:
Devising a remuneration package for executive directors and senior managers
that gives them an incentive to act in the best interests of the shareholders.
Remuneration packages may therefore provide rewards for achieving a mixture
of both long-term and short-term financial targets and non-financial targets.
Having a large proportion of debt on the long-term capital structure of the
company.
Having a board of directors that will monitor the decisions taken for the
company by its executive management.
In addition, agents (management) should be held accountable to the principal
(shareholders).
Providers of debt
Jensen and Meckling argued that the problems of the agency relationship are bigger
in companies that are profitable but have low growth in profits. These companies
generate a large amount of free cash flow.
Free cash flow is cash that can be spent at the discretion of management, and does
not have to be spent on essential items such a payment of debt interest, taxation and
the replacement of ageing non-current assets.
It is in the interest of shareholders that free cash flow should be either:
invested in projects that will earn a high return (a positive net present value), or
paid to the shareholders as dividends.
The directors and other senior managers of a company might want to invest free
cash flow in projects that will increase the size of the company. These could be
projects that will earn a high return. In a low-growth company, however, it is likely
that managers will want to invest in projects that increase the size of the company
but are only marginally profitable and would have a negative net present value.
One way of reducing this problem would be to have a high proportion of debt
capital in the capital structure of the company. Interest must be paid on debt, and
this reduces the free cash flow. Management must also ensure that new investments
are sufficiently profitable so that the company can continue to pay the interest costs
on its debt capital.
The board of directors
A different method of reducing the agency problem is to make the board of
directors more effective at monitoring the decisions of the executive management.